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Cheap oil, cheap money

The oil-price drop claimed plenty of victims, but the winners have been less noted.

In January the price of Brent crude dipped so low that, for a short time, oil was cheaper than bottled water.

It has since climbed back to $50 per barrel, still far below its 2014 high of $115, but not far off its five-decade average of $55. Cheap oil hit the producers hard – numerous shale oil companies were forced to renege on debt repayments, while the oil majors suffered hefty profit downturns. A number chose to cut their ordinary dividends as a result.

“We are underweight oil,” says Imran Sattar, fund manager at BlackRock. “Shell is best-placed as it’s a low-cost operator. We owned BG (the Brazilian oil company bought by Shell this year) because, unlike the oil majors, it was actually growing its production. It’s enjoying double-digit growth.”

Yet as oil majors struggled, the beneficiaries of cheap oil were less talked about. A low oil price should provide a boost to consumers, since the products they buy rely on oil to make it to the shop floor – or to the consumer’s front door. Data collected for the ASDA Income Tracker, which records changes to disposable income, suggests there has indeed been a boost. Yet that does not mean that consumers have simply spent the difference.

“Cheap oil has definitely helped consumer expenditure, as the ASDA Income Tracker goes to show,” says Ewen Cameron Watt, chief investment strategist at BlackRock. “[At the same time], savings ratios have risen on both sides of the Atlantic.”

Indeed, in terms of raw numbers, the proportion of increased spending power that consumers have chosen to deploy looks similar on either side of the Atlantic.

“Around 40–50% of the cheap oil windfall has been spent – non-discretionary spending has been boosted in the US,” says Sattar. “It’s probably little different in the UK.”

On both sides of the Atlantic, consumers are choosing not to deploy all their windfalls, thereby limiting the impact on broader economic growth. Yet the biggest reasons for this thriftiness are different in the US than in the UK.

“One reason consumer expenditure didn’t pick up more quickly in the US is the increase in healthcare insurance costs following the Affordable Care Act, especially in hospital equipment,” says Cameron Watt. “The gradient of health expenditure is [now] expected to flatten quickly. In the UK, some non-spending [of the extra discretionary income] was related to the awareness that there is less investment income around – so it was a good time to increase your savings.”

Yet if local specifics are important, so too is the broader role of perception in consumer behaviour. Thus, what consumers really respond to is not so much falling prices as rising salaries.

“Some of the slow pick-up is due to ‘money illusion’,” says Cameron Watt. “Spending is largely from changes in nominal income – even if price purchasing power increases – due to how it feels.”

Money illusions

At least consumers have not been spending too much. In April this year, 11 US oil companies filed for ‘Chapter 11 bankruptcy'1, the highest number since the oil price began to reverse in late 2014.2 The bankruptcies reflect not simply the shift in the oil price but the ready accessibility that US shale companies had to credit lines. Among the oil majors, on the other hand, some have cancelled or shaved dividends, while others have chosen to pay them in full, despite falling revenues.

“BP and Shell are over-distributing – they are running the business to pay a dividend,” says Cameron Watt.

If there is a glut of oil, there is also a glut of money (aided by a tide of low interest rates), and it also has enormous power to destabilise. In some cases, assets may be overpriced, while the ability to borrow cheaply can tempt companies to over-extend themselves, creating problems in the long term.

Thus, although it is part of a longer-term trend, it is notable that the number of AAA-rated companies in the US continues to fall – it is the companies’ debt levels that have been driving down their ratings. Exxon Mobil lost its AAA rating earlier this year, taking the US total to just two: Microsoft and Johnson & Johnson.

Central banks have not only launched enormous programmes of quantitative easing; they have also dropped interest rates to historic lows. A number of the largest have even pushed rates into negative territory. These policies have also had the effect of pushing down the yields (i.e. what you get back as a lender) on longer-term debt, a process known in the industry as ‘flattening the yield curve’.

That creates pressures for a range of different sectors, not least banking and insurance. Life insurance products only look attractive if there are sufficiently high long-term yields on government debt. When those long-term yields fall, investors are more likely to buy short-term products.

“Central banks are harming the insurance industry due to the flattening and shifting down of the yield curve, which is clearly helping to hobble insurers,” says Cameron Watt. “Insurance is becoming less profitable, which is the opposite of the usual life insurance model. The dividend model therefore looks stretched, especially for continental European insurers.”

BlackRock is a fund manager for St. James’s Place.

The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested. The opinions expressed are those of Ewen Cameron Watt and Imran Sattar and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.

1 Also known as ‘rehabilitation bankruptcy’

2 According to Haynes and Boone, a Dallas-based law firm

Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.

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